Few things get me fired up like the talking heads of Wall Street talking at me. I have the credentials. I know the world of investments and finance. And yet, these Wall Street “experts” always seem to invent new words and overcomplicate things – and on purpose (my humble opinion). If the process of investing seems way too complex for the average Joe to do it on his own, then brokers get to inflate their fees. It’s not all doom and gloom obviously, but investing just isn’t that difficult. That’s why I want to spend some time taking you through the ins and outs of investing over the next few articles calling it “Investing 101.” This is part one, asset types. Join me as I uncover the mystery of investing for business owners, making it the way it ought to be—financially simple.
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I like to keep things simple. When I think of difficult concepts, I often simplify it in my head so that I learn it and I don’t have to think about it again. In fact, one of my favorite philosophies is the KISS philosophy: Keep It Simple, Stupid. Now, whenever I say that, I’m talking to myself, but it reminds me to just keep things simple. In that same context, there’s no need to overcomplicate asset types.
Sure, some people would tell you there are a million different types of assets — and in some regards, they’re right — but I believe it’s much simpler than that. In truth, there are only three basic asset types: stocks, bonds, and cash. If you want to use the industry terms, equities, fixed income, and cash equivalents but for my simple mind, stocks, bonds, and cash work just fine.
I want to assure you that I know there are more to equities than just stocks. Likewise, there is more to fixed income than bonds. I am well educated in each of these areas and my company manages millions of dollars for my clients each day. The point, however, is to keep this simple.
At their core, stocks are just a way to build wealth. When you invest in an asset type like stocks, you are purchasing a share of the company that you’ve just invested in. In essence, you are a partial owner. One of my favorite jokes, when I’m out shopping with my wife and kids, is to walk into a store and say, “Look, I own this store!” And I can do that because I own stocks. I want Bass Pro Shop to do well because I am a shareholder, and I love hunting and fishing but that’s another discussion.
When we, as ordinary people, invest, we can’t just walk into Bass Pro Shop and say, “Here’s $1,000! I want to buy some stock.” So what do we do? We turn to the stock exchange and go through an intermediary to buy shares of stock in the company. But why should we own stock?
BTW – I’m not endorsing Bass Pro Shop as an investment for you. Please do your own due diligence or speak with your advisor.
RELATED READING: An Overview of Basic Investments – Setting The Stage
When you own stock in a company, typically, the business appreciates in value. As their revenues go up, so should the values of their stock. Thus, increasing or appreciating the value of your portfolio. So one of the reasons for owning stock is the anticipation that it will appreciate over time. But that’s not the lone reason for owning stock.
Often times, stocks will pay dividends. What do I mean by that? Well, I like to think of it in terms of rent. I’ve owned several rental homes in my lifetime. We are all familiar with the concept. I own the home and the renters pay me a monthly stipend to live there. That’s really the same concept as stock dividends. You buy the stock with the anticipation that, over time, it will grow in value but you also earn interest on your investment, which is paid to you in dividends.
Historically speaking, the stock market gives a pretty decent return for our portfolios. However, historical success does not guarantee future gains. There are stocks that flounder and fail all the time, so don’t think you’re going to go out and buy a bunch of different stocks and have it made in the shade. That outcome is few and far between, but there are many people who have found success by diversifying or expanding their portfolios.
When there is a potential for a great reward, there is also the potential for great loss. Diversification is a way of getting the maximum benefit while mitigating the risk involved. We will address this term, diversification in greater detail in a future post, but for now, simply put, diversification is not putting all of your eggs in one basket. You want to buy stocks across many industries, sizes, position, and geographic areas. You also want to put your money into companies of different sizes.
ADDITIONAL INFORMATION: How Diversification Strengthens Your Investment Portfolio
When we look at the various stock options that are available to the investor, we see terms like growth and value, large-cap, small-cap, and mid-cap. But what do each of these terms mean, and why should they concern you and your investments? Let’s continue to break these down into financially simple terms.
Large-cap corporations are the very same that you see on the S&P 500 — the market index of the 500 plus largest companies listed on the stock exchange — and have a market capitalization greater than $10 billion. These are companies like Apple, Amazon, and Google. (BTW – You can not invest directly into an index…)
Below that large-cap threshold are mid-cap companies. These businesses have a market capitalization ranging from $2 billion to $10 billion. And even further down the totem pole, we have small-cap corporations which range from $300 million to $2 billion in capitalization. “Okay, Justin. What’s your point?”
Well, when you look at the risk versus the rate of return of these companies, you’ll notice an inverse relationship. The small-cap companies often offer you the highest potential growth, but they are generally pretty volatile investments. This means that you have just as much opportunity to make a fortune as you do to lose one.
However, large-cap companies are nice and stable. You won’t see huge gains from your investments in large-cap corporations, but you can often yield a safe and steady return on your investment. This is why keeping your portfolio balanced is so important to growth and stability.
These are terms that you have likely heard before, but what do they really mean? What’s the difference between them? Growth stocks typically generate revenue, cash flow, and profits faster than industry averages. Value stocks, on the other hand, trade at lower prices relative to their fundamentals. Basically, this means that the stock is being undervalued. If it’s worth $20 per share, it might be sold for $16 per share.
So value stocks are sold at a value to the investor and growth stocks provide almost immediate returns because the company is growing. When you’re building your portfolio, it is vitally important to incorporate a healthy mix of each of these large, mid, small-cap, growth, and value stocks. By spreading your eggs throughout several baskets, you stand the best chance for seeing positive returns.
Technically fixed income is debt. I know that I’m oversimplifying this but for the sake of keeping things simple, humor me for a moment. If I go to the bank to borrow money for a new car, I will have to pay interest throughout the term of the loan. Well, when we are dealing with bonds, which are a form of fixed income, you’re taking on the role of the bank.
Essentially, you are giving the issuing corporation — or government entity — a loan that they agree to pay back, with interest, on a predetermined date. With that in mind, you probably think that bonds are a pretty safe investment, right? That question actually deserves a yes and no answer.
You see, bonds are just a different type of risk. If I were given the option of buying bonds from New York City or from Ty Ty, Georgia, which municipality do you think has the means to pay off that debt? New York, New York has a much larger population to pull tax revenue from so it is more likely that they would be in a position to pay the interest on my loan.
Traditionally, cash is relatively low risk. However, you want to put your money to work so that it is building wealth for you. So, simply stowing it away under the mattress isn’t the best idea. Mostly because inflation kills the value of the dollar. But there are plenty of cash equivalents — T-Bills, bank CDs, money market accounts, and other things of that nature — that can help to grow the cash you’ve placed into them while also being readily convertible to cash.
Inflationary risk can be a killer. If you’re tempted to just hoard cash, think about this, you’re dollar will never be as valuable as it is right now. So, rather than just storing depreciating paper, put it to work! At the bare minimum, place it into a money market account and collect 2, 3, or even 4% interest on it.
There you have it, understanding investing is simple. It really is just stocks, bonds, and cash when you take it down to the basics. Now, there’s definitely more to know about this subject, and I will dive into that a little further in my next post. But for now, just know that life is hard. Life is complicated, but with the right understanding, investing can at least be financially simple.
Stay with us for Part II of this series where we tackle understanding risk tolerance. And be sure to get the most out of investing by following along with the whole Personal Finance for the Business Owner series.